Unless you’ve been living under a rock recently, you will recognise that climate-related reporting requirements have become an increasing priority whilst the complexities surrounding climate reporting have gained recognition for being unclear and intimidating for businesses, especially small and medium sized enterprises (SMEs) to navigate due to a patchwork of reporting frameworks, a plethora of regulation and an ‘alphabet soup’ of abbreviations and acronyms.
In a recent ICAEW webinar, Getting started with climate reporting, 92% of attendees admitted to having less than limited experience of climate reporting, or none at all. The time to get started with climate reporting is now.
More transparency, less subjectivity
What is clear, is that it’s going to require a collaborative effort from standard setters, accounting firms, regulators, investors and companies to improve transparency and reduce subjectivity around climate reporting.
There needs to be one set of sustainability standards to adhere to, a new global baseline for businesses to disclose their sustainability risks and opportunities, for both mandatory and voluntary disclosures. The International Sustainability Standards Board (ISSB) answered this need by launching its first two standards (S1 and S2) in June 2023:
- IFRS S1 General Requirements for Disclosure of Sustainability-related Financial Information.
- IFRS S2 Climate-related Disclosures.
These standards bridge the information gap, facilitate greater consistency, and provide quality information to the investor community. This will enable the community to make more informed decisions on a company and its prospects.
Set to take effect in January 2024, S1 and S2 were developed from two widely adopted existing frameworks, Taskforce on Climate-Related Financial Disclosures (TCFD) and SASB Standards. S1 and S2 focus on integrating climate-related metrics and financial statement impacts, as well as the overall implications for financial reporting, highlighting a distinction from the existing frameworks.
A firm supporter of the ISSB since its launch, the UK government indicated it will explore adopting ISSB’s standards with two adapted UK-centric versions, aiming to make endorsement decisions on its first two standards by July 2024.
Why are these standards important?
With sustainability pressures and incentives creating a shift in corporate activity to achieve a net zero economy, we know that companies are under scrutiny from regulators, investors and the UK government, to better manage their own climate-related risks and their impact of the environment. Further, the environmental, social, and governance (ESG) approach to investing is evolving at a rapid pace, with many investors now taking ESG into account as part of appraising their next investments.
Following concerns raised by investors and surmounting industry pressure to adequately address climate-related matters in financial reports and audits, S1 and S2 mark a significant step in the right direction. We explore these in detail below.
S1 and S2 details
S1 sets out the general requirements for Disclosure of Sustainability-related Financial Information and requires businesses to disclose information about sustainability-related risks and opportunities in general purpose financial reports. These risks and opportunities are those that could reasonably be expected to affect a business’s cash flow, access to finance or cost of capital over the short, medium, or long-term.
In the UK, this is likely to be the Strategic Report or the Operating and Financial Review, with an expectation that the assumptions used for sustainability reporting purposes will align with the data used for financial reporting purposes, and other commentary elsewhere in the annual report which will require thought and possibly change in the wider financial statements.
S1 is expected to apply to any entity, irrespective of which financial reporting standards are being adopted (eg UK GAAP or UK-adopted IFRS), thereby extending the reach of the standard beyond the largest listed companies, and may support businesses to adopt on a voluntary basis. The core content of the standard is based upon the four pillars of the TCFD:
- Governance – the governance processes, controls and procedures the entity used to monitor and manage sustainability-related risks and opportunities.
- Strategy – the approach the entity uses to manage sustainability-related risks and opportunities.
- Risk management – the processes the entity uses to identify, assess, prioritise and monitor sustainability-related risks and opportunities.
- Metrics and targets – the entity’s performance in relation to sustainability-related risks and opportunities, including progress towards.
These pillars should be familiar in the UK as certain listed entities have been required to apply the full TCFD recommendations. Other Public Interest Entities, AIM companies and large private companies and LLPs, have also been required to include TCFD-aligned disclosures since 2022. However, compliance with the current UK regulations would not ensure compliance with S1 and S2.
S2 focuses specifically on climate-related disclosures, requiring businesses to disclose information about climate-related risks and opportunities which may be physical, and event driven (eg fires, floods or long-term shifts in the climate) or transitional (eg a response to transitioning towards a lower-carbon economy) and focuses on the same four areas as S1: governance, strategy, risk management and metrics and targets.
The implications for SMEs
S1 and S2 will undoubtedly present difficulties for SMEs as the metrics and targets needed under S2 are extensive and require disclosure of three key elements:
- Information relevant to cross-industry metric categories; these would apply (where material) irrespective of the industry in which the business operates, and includes specific metrics related to Greenhouse Gas Emissions, climate-relate transition risks, climate-related physical risks, climate-related opportunities, capital deployment, internal carbon prices and remuneration.
- Industry-based metrics – these are metrics where a business operates in a specific industry, for example consumer goods, the financial sector, healthcare, transportation etc. These are set out in a separate industry-based guidance document.
- Any targets required to meet law or regulation.
Attempting to comply with these standards for the first time will be challenging for SMEs, as S1 and S2 represent a significant step-change from the current reporting practices in the UK. This could potentially result in criticism for failing to comply, as SMEs could be compared to larger businesses that have the ability to meet all requirements.
A statement of compliance with the IFRS Sustainability Disclosure Standards is, at this time, only permitted if all requirements are complied with. To encourage all businesses to do the right thing and meet requirements as best as they can, ISSB should outline a scalable solution for all, instead of adopting an all or nothing regime for compliance.
Key challenges facing UK businesses
One of the challenges facing UK businesses is the need to consider the climate resilience of their strategy and business model. Businesses will need to use climate-related scenario analysis, such as assessing the impact of several hypothetical situations using a set of assumptions and inputs. To make these requirements scalable, they could consider the extent of the exposure to climate-related risks and opportunities as well as the skills, capabilities, and resources available to them in carrying this out, but it must consider all reasonable and supportable information that is available without unnecessary cost or effort.
Other key sustainability-related changes are also unfolding in the European Union (EU). The Corporate Sustainability Reporting Directive (CSRD) is expected to take effect from financial years beginning January 2024. Organisations are required to provide a detailed outline of sustainability disclosures, including anticipated risks and opportunities pertaining to environmental and social issues and although this is an EU law, it is anticipated to impact around 50,000 UK businesses.
Further, the European Commission recently released a set of 12 European Reporting Standards (ESRS) effective from 2024 for large businesses across the EU. They are mandatory for use by businesses required by the EU Accounting Directive to report sustainability information. Both reporting initiatives are subject to double materiality, meaning businesses will need to report on their impacts on social and environmental issues and potential risks.
With these imminent changes, coupled with the S1 and S2 (and the expectation that S3, S4 and so on will follow), doing nothing at this stage is not an option.
How we can help
At Saffery, we support the ISSB’s efforts in creating a more streamlined strategy for reporting climate-related and financial disclosures and advocate the importance of ESG to support our clients in reviewing the climate-related opportunities and risks of their businesses, but to also support the industry as a whole in improving transparency around climate-related matters.
If you’d like to discuss any of the topics mentioned above, or you’re ready to get started with climate reporting for your business, please get in touch with Stuart Macdougall.